The Consequences of Failing to Report Loss Transactions to the IRS

The Internal Revenue Code requires U.S. taxpayers to disclose certain transactions resulting in significant losses. The Internal Revenue Service (IRS) classifies these as “reportable transactions” due to their potential to serve as abusive tax shelters; and, as the IRS makes clear, “[e]ach taxpayer that has participated in a reportable transaction and that is required to file a tax return must disclose information for each reportable transaction in which the taxpayer participates.” In this article, Texas tax controversy lawyer Lawrence Brown discusses what high-income and high-net-worth taxpayers need to know about the IRS’s ongoing efforts to target fraudulent loss transactions—and the consequences these taxpayers can face if they fail to report loss transactions to the IRS.

Loss Transactions Subject to Mandatory Disclosure Under the Internal Revenue Code

Reportable loss transactions are determined based on taxpayers’ aggregate losses not only in a single year but also in “any combination of tax years.” The thresholds vary for different types of taxpayers, and there are special rules for losses from foreign currency transactions in some cases:

• Individual Taxpayers – Individual U.S. taxpayers must report losses of $2 million or more in a single tax year or $4 million or more in any combination of tax years.
• Corporate Taxpayers (excluding S Corporations) – Corporate taxpayers, excluding S corporations, must report losses of $10 million or more in a single tax year or $20 million or more in any combination of tax years.
• Partnerships with Only Corporations as Partners – Partnerships that have only corporations as partners, excluding S corporations, must report losses of $10 million or more in a single tax year, or $20 million or more in any combination of tax years, “whether or not any losses flow through to one or more partners or shareholders.”
• S Corporations and Other Partnerships – S corporations and partnerships not covered by the previous category must report losses of $2 million or more in a single tax year, or $4 million in any combination of tax years, “whether or not any losses flow through to one or more partners or shareholders.”
• Trusts – Trusts must report losses of $2 million or more in a single tax year or $4 million in any combination of tax years.
• Losses from Foreign Currency Transactions – Individual U.S. taxpayers and trusts must report losses from foreign currency transactions covered by Section 988 of the Internal Revenue Code if these losses total at least $50,000 in a single tax year.

The IRS refers to these as Section 165 losses based on the relevant provision of the Internal Revenue Code. For owners of pass-through entities, disclosure is required if they receive an allocation of a reportable loss.  As the IRS explains, “[i]f you are a partner, shareholder, or beneficiary of a pass-through entity, you have participated in a loss transaction if your tax return reflects a section 165 loss allocable to it from the pass-through entity that equals or exceeds the applicable threshold amount.”

Although there are exceptions to the loss reporting requirements listed above, these exceptions only apply in limited circumstances. Perhaps the broadest exception is the one that applies to losses from the sale or exchange of assets with a “qualifying basis.” Other exceptions include those applicable to theft, casualties, mark-to-market treatment, and certain swap transaction losses. While these exceptions can serve as effective defenses to non-disclosure in relevant cases, more often than not, targeted taxpayers will need to work with their counsel to identify alternate defense strategies.

The Risks of Failing to Disclose Reportable Loss Transactions to the IRS

High-income and high-net-worth taxpayers can face substantial penalties as a result of failing to disclose reportable loss transactions to the IRS. While these penalties are most often civil in nature, the IRS can work with the U.S. Department of Justice (DOJ) to pursue criminal charges in cases involving willful tax evasion and tax fraud.

In civil enforcement actions, the IRS can impose accuracy-related penalties as well as penalties for failure to pay and failure to file. These penalties are calculated as a percentage of the amount owed, with failure-to-pay and failure-to-file penalties imposed on a monthly basis subject to a statutory maximum aggregate penalty.

In criminal enforcement actions, taxpayers accused of failing to disclose reportable loss transactions in order to evade or defeat tax can face substantial fines, and individual taxpayers can also face terms of federal incarceration. For example, the federal tax evasion statute imposes a corporate fine of up to $500,000 and an individual fine of up to $100,000 plus five years of imprisonment.

Defending Against an IRS Audit or Investigation Targeting an Alleged Abusive Tax Avoidance Scheme

Even when high-income and high-net-worth taxpayers are able to avoid substantial penalties for failing to properly disclose reportable loss transactions, these types of failures can lead to enhanced scrutiny from the IRS going forward. As a result, in all cases, it is critical to work with experienced legal counsel who can assess your risk, assess all possible defense strategies and communicate effectively with the IRS on your (or your company’s) behalf.

As with all types of abusive tax shelters, facing scrutiny from the IRS for allegedly failing to disclose a reportable loss transaction requires an informed, strategic and proactive approach. Due to the risks involved, taxpayers targeted in these audits and investigations cannot afford to take chances. The IRS is prioritizing enforcement against high-income and high-net-worth individuals and corporations, and it works swiftly with the DOJ and its other law enforcement partners to pursue wide-ranging indictments when it determines that criminal enforcement is warranted.

Request an Appointment with Texas Tax Controversy Lawyer Lawrence Brown

If you need to know more about the IRS’s ongoing efforts to target individual and corporate taxpayers for failing to properly report loss transactions, we encourage you to contact us promptly. With offices in Fort Worth, we work with high-income and high-net-worth taxpayers throughout Texas and nationwide. To request an appointment with Texas tax controversy lawyer Lawrence Brown, please call 888-870-0025 or contact us confidentially online today.